Tech giant’s aim is to boost a cloud-computing business central to CEO Rometty’s effort to revive the company Red Hat has grown into the dominant provider of the Linux operating system to corporations. PHOTO: VACLAV SALEK/ZUMA PRESS 31 COMMENTS By Jay Greene and Robert McMillan Updated Oct. 28, 2018 5:28 p.m. ET International Business Machines Corp. IBM -1.31% agreed to buy software-and-services company Red Hat Inc. RHT -3.19% for about $33 billion in its biggest acquisition ever, a deal aimed at helping IBM Chief Executive Ginni Rometty boost a cloud-computing business central to her efforts to revive the tech giant. IBM rivals Amazon.com Inc. and Microsoft Corp. have jumped ahead of it in recent years in the business of providing computing power and software for rent. But Ms. Rometty said in an interview that the market is moving into a second chapter in which customers will want to work with multiple cloud providers. That should boost interest in so-called hybrid services in which companies run programs that use computing resources from their own servers and web services from IBM and others at the same time, she said. “This is an inflection point,” Ms. Rometty said. Red Hat will help IBM with that effort because it is a leading provider of open-source software and services that help companies bridge different platforms, she said. The deal comes nearly seven years into Ms. Rometty’s struggle to revamp the 107-year-old company by shrinking older, slower-growth lines of business and focusing heavily on cutting-edge technologies like artificial intelligence and cloud computing. That effort led to nearly six years of falling revenue, which IBM finally reversed in January with three straight quarters of growth. But in the latest quarter IBM’s revenue dipped 2.1%, despite the booming corporate tech-buying market. IBM’s stock price is down 19% over the past year. For this year, analysts expect IBM to record $79.75 billion in revenue and adjusted profits of $13.80 a share, according to S&P Global Market Intelligence. In 2011, the year before Ms. Rometty became CEO, IBM posted $106.92 billion in revenue and adjusted profits of $13.44 a share. IBM plans to pay $190 a share for Red Hat in what IBM said would be its largest acquisition ever. IBM plans to use cash and debt to make the acquisition. At the end of the third quarter, it held $14.7 billion in cash. Turnaround Stalls IBM returned to declining quarterly revenue after a brief streak of gains. Source: S&P Capital IQ IBM is paying an unusually large premium in the deal, at 63% above Red Hat’s closing stock price of $116.68 on Friday. IBM said that the deal, including debt, is worth $34 billion. Using Red Hat’s most recently disclosed number for shares outstanding, the equity value of the deal is just under that. Founded 25 years ago, Red Hat has grown into the dominant provider of the Linux operating system to corporations. While Linux is available free of charge, Red Hat sells a version of Linux that contains software enhancements and the high level of technical support that corporations require. The company reported $2.9 billion in revenue for its most-recent fiscal year, which ended in February 2018. “IBM has deep, deep customer expertise…in a way that can dramatically accelerate our business,” Red Hat CEO Jim Whitehurst said in an interview. For IBM, Red Hat’s Linux and other software assets represent an opportunity to sell products to corporate software developers who are building complex applications that can run on both cloud-computing platforms such as Amazon and Microsoft as well as in-house data centers. “I think this is a very good and strategic move for IBM,” said Crawford Del Prete, chief operating officer with the industry research firm International Data Corp. “Red Hat has done a fantastic job over the last few years becoming relevant to developers and helping developers not only with Linux, but also with the tools on top of Linux.” Red Hat, based in Raleigh, N.C., will operate as a distinct unit within IBM’s Hybrid Cloud team. And IBM intends to retain all of Red Hat’s roughly 12,600 employees, Ms. Rometty said. IBM currently has just under 370,000 employees. As companies move more of their computing to the cloud, they’re choosing multiple cloud providers—Amazon and Microsoft for cloud-infrastructure, for example, andSalesforce.com Inc. and Workday Inc. for applications. Ms. Rometty is betting that Red Hat will help IBM offer software and services to help companies bridge those technologies with applications that run in their own data centers. “Already they can see what I would call cloud sprawl, and they have to have a way to manage it,” Ms. Rometty said. Open-source software is key because it eases customers’ ability to move their computing among various cloud providers and from their own data centers. The challenge for IBM is that rivals have raced ahead in the business. In the world-wide cloud-infrastructure market, IBM had 1.9% share of revenue in 2017, according to market-research firm Gartner Inc. Market leader Amazon took 51.8% of the market. IBM also trailedMicrosoft, Alibaba Group Holding Ltd. and Alphabet Inc.’s Google. Red Hat provides IBM with its flagship operating system, Red Hat Enterprise Linux. The software company has focused its resources on a new product called OpenShift, which lets corporate software developers build programs that run on specialized software, called containers, which can in turn be run either in corporate data centers or on the cloud. Having Red Hat’s Linux and container software in its product portfolio will help IBM remain relevant to corporate developers who are looking to leverage cloud computing, said Mr. Del Prete of IDC. Within Red Hat on Sunday, some employees expressed concerns that the acquisition could tamp down Red Hat’s more freewheeling corporate culture, where employees are encouraged to participate in the development of open-source software projects, even if they are not core to Red Hat’s business. “There’s still a very passionate core at Red Hat who really believe in the open-source mission,” said one employee. Another Red Hat employee said he was also worried that its culture would change, but said he expected IBM’s marketing might and its wide sales reach among global corporations would be a boon for Red Hat. “If we can leverage those resources and continue to operate the way we are, that might be the best of both worlds,” he said. IBM intends to retain Red Hat’s culture, as well as its brand, Ms. Rometty said. IBM said the deal will start to boost its free cash flow and gross margin within 12 months and accelerate revenue growth. The acquisition, which has been approved by the boards of both IBM and Red Hat, is expected to close in the latter half of 201
https://www.forbes.com/sites/kpmg/2018/10/01/speed-to-market-accelerate-stay-secure/#3cdc9c71739b Red Hat provides services for its version of the open-source (free from licensing costs) Linux software operating systems, middleware, storage, virtualization, and management tools. The company reports revenue through two categories: subscriptions, and training and services. The Americas contributed approximately 64% of total revenue in fiscal 2018; Europe, the Middle East, and Africa contributed 23%; and Asia-Pacific contributed 14%, according to Morningstar. Red Hat is a steadily growing and profitable company that throws off lots of cash. In the last five years, sales have increased at a 17.1% annual rate to $2.92 billion, net income rose at an 11.5% annual rate to $259 million, and free cash flow grew at nearly a 19% annual rate to $821 million, according to Morningstar. Sadly, Red Hat slipped in its most recent quarter. That's when it missed analysts’ expectations for sales and its forecast for the current quarter also fell short -- investors may have been concerned that Red Hat was losing deals to rivals and that growth might be slowing, according to Bloomberg which noted that Red Hat shares are down 28% percent over the past six months through October 26. Is this deal a good thing for IBM shareholders? Investors do not love this deal -- sending its shares down over 4% on October 29. And I think it fails three of the four tests for successful acquisitions. (I have no financial interest in the securities mentioned in this post). YOU MAY ALSO LIKE To be fair, Red Hat competes in an attractive industry. However, the combined companies will not be better off, IBM grossly overpaid, and it will be difficult to integrate the two companies. Industry Attractiveness: Pass Red Hat's industry -- providing service and training for companies that use open source software -- is large, growing, and profitable. As Red Hat CEO, Jim Whitehurst, said in an SEC filing, "We believe our total addressable market to be $73 billion by 2021. If software is eating the world - and with digital transformation occurring across industries, it truly is - open source is the key ingredient." What's more, IDC reported that with 32.7% of the server operating system market in 2017 -- Red Hat lagged only Microsoft. Within the Linux segment, IDC found that Red Hat Enterprise Linux adoption grew by nearly 20% in 2017. Better Off: Fail To be sure, IBM and Red Hat touted the deal as a way to compete with Amazon and Microsoft in the so-called hybrid cloud. But IBM's approach to integrating acquisitions makes it highly unlikely that the combined companies will be able to get their act together to offer customers a better service and gain market share. For one thing, IBM is famous in its acquisitions for imposing internal requirements on its products -- the products must appear to all work together forcing customers to accept a clunky bundle rather than a more focused, efficient solution. While IBM has been shipping servers with Red Hat for years -- and this deal will save IBM from paying Red Hat for that, it remains to be seen how well this deal will result in a cloud service that can boost IBM's measly 1.9% share of cloud infrastructure revenue in 2017. What's more, companies have bought Red Hat products because it was considered vendor neutral. Whitehurst, told CNBC that the combined company would be the largest contributor to open-source software. "We will [also] remain distinct because we want our customers to understand that Red Hat coming in is a neutral sell." But as part of IBM, Whitehurst will have an insurmountable challenge in trying to explain how Red Hat can be both neutral and not try to make the acquisition pay off by encouraging customers to buy from IBM. This will be especially difficult as he loses control over its product line and go-to-market strategy due to Big Blue's bureaucracy. Net Present Value Greater Than Zero: Fail By paying so much for Red Hat, it will take some heroic assumptions for this deal to generate a positive net present value. IBM has about $80 billion in annual revenue and Red Hat would add a mere 3.8 percent to Big Blue's top line. This is not much but it could end up being worse. After all, it assumes that customers stick with Red Hat once it is owned by IBM. Of course, companies who previously bought from Red Hat because it was perceived as neutral, may decide to switch to a still-independent rival. Moreover, Red Hat would only add 6% to IBM's free cash flow. To be sure, I have no doubt that it's possible to make assumptions that would cause this 63% premium to result in a positive net present value. But I think IBM is overpaying. Integration: fail One of the key reasons that mergers fail is because the acquired company can't retain the best people in the acquired company. One factor causing people to leave is a change in its culture. And Red Hat believes that preserving its culture is critical to its success. According to its latest annual report, We believe that a critical contributor to our success has been our corporate culture, which we believe fosters innovation, creativity and collaboration. As our organization grows, our employees (including remote workers) and our resources become more globally dispersed and our organizational management structures become more complex, we may find it increasingly difficult to maintain these beneficial aspects of our corporate culture. If we are unable to maintain our corporate culture, we may find it difficult to attract and retain motivated employees, continue to perform at current levels or execute on our business strategy. As a result, our business, financial condition, operating results and cash flows could be adversely affected. Will this culture survive being acquired by IBM? Given how big the gap is between IBM's actual culture and the one built by Thomas Watson, I would vote for no. But Rometty told the Wall Street Journal that IBM intends to retain Red Hat’s culture and brand. To be fair, this is an outstanding deal for Red Hat shareholders who will no doubt enjoy the huge premium IBM paid. Sadly, IBM shareholders are likely to be disappointed by the deal's failure to pass the four tests for successful acquisitions.
I don't get it. RedHat annual income is $259M. IBM paid $34B. So, it would take $34B / $259M = 131 years 131 years for IBM to get even on that investment?